ProfessorBainbridge.com

KPB on "Do Ineffective Internal Controls Expand A Shareholder's Right Of Inspection?"

Keith Paul Bishop reports:

Section 1601 of the California Corporations Code establishes a shareholder's right to inspect the "accounting books and records and minutes of proceedings of the shareholders and the board and committees of the board".  A shareholder's inspection, however, must be for a "purpose reasonably related" to the shareholder's interest as a shareholder. Id.  This is commonly referred to as a "proper purpose" requirement.

When a corporation provides its audited financial statements to its shareholders, can a shareholder have a proper purpose in seeking inspection of the underlying financial records?  Professor Harold Marsh Jr. theorized that in such cases, a shareholder would have to show that "there was some substantial reason to believe that the reports submitted to the shareholders were erroneous".  Marsh's California Corporation Law §15.09[B].  

In  Farnum v. Iris Biotechnologies, 2018 Cal. App. Unpub. LEXIS 8069, the California Court of Appeal took note of a corporation's disclosure in its Form 10-K that management had concluded that the corporation's internal controls over financial reporting were not effective.  Thus, the Court concluded that the company had recognized that its "audited financial statement" [sic] was "incomplete".  This is an odd statement in light of the fact that the company's Form 10-K included the requisite financial statements and an auditor's opinion.  Nonetheless, the case is an example of ineffective internal controls over financial reporting providing a basis for expanded shareholder inspection.  The opinion, however, is not precedential because the court did not certify it for publication or order it to be published.

"The Costs and Benefits of Shareholder Democracy"

Gantchev, Nickolay and Giannetti, Mariassunta, The Costs and Benefits of Shareholder Democracy (October 18, 2018). SMU Cox School of Business Research Paper No. 18-35. Available at SSRN: https://ssrn.com/abstract=3269378

We show that while low-cost shareholder activism via shareholder-sponsored proposals is occasionally value-enhancing, many proposals are submitted by the same few individual investors and other sponsors without organizational capabilities to analyze a large number of firms. These proposals if approved and subsequently implemented appear to destroy shareholder value. We show that firms whose shareholders are more likely to collect information before voting benefit from low-cost shareholder activism because these investors weed out low-quality proposals. We conclude that an informed shareholder base is crucial for firms to take advantage of low-cost shareholder activism.

As I suspected!

Delaware judges must hate trees

From friend of the blog/Delaware lawyer Francis Pileggi:

In connection with analyzing claims that certain defendants aided and abetted breaches of the directors’ fiduciary duties, a recent Court of Chancery opinion provides an exemplary recitation of important fundamental principles of Delaware corporate law. The court’s decision in the case of In re PLX Technologies Inc. Stockholders Litigation, Cons. C.A. No. 9880-VCL (Del. Ch. Oct. 16, 2018), is a 136-page mini-treatise that explains key tenets of Delaware corporate law in the context of a challenged acquistion.

With all due deference to the learned counselor, but 136 pages is not "mini"!

In any event, Pileggi highlights the take-home points in a most helpful way.

Delaware clears up some Kahn v. M&F Worldwide questions

Ann Lipton has a great summary:

This week, the Delaware Supreme Court decided Flood v. Synutra, and began to clear up some of the questions left open after its earlier decision in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”).  ...

In MFW, the Delaware Supreme Court held that if a controlling shareholder employs both protections, and makes clear from the outset that any deal will be conditioned on their satisfaction, and there is no reason to think the protections were circumvented (i.e., the committee acted with care, was fully empowered, and so forth), the resulting deal will get business judgment review.  But a lot was still left open.

For one thing, MFW had this odd footnote that suggested that an independent committee’s lack of care/bargaining power might be demonstrated, for pleading purposes, by a showing that the deal price was insufficient.  The footnote was odd because normally a lack of care is not pled by challenging a substantive outcome; allowing it in this instance suggested the Court was not entirely confident that MFW’s dual protections truly substituted for an arm’s-length deal.  And for another thing, MFW did not specify how early in the process the controller would have to disable itself to be entitled to business judgment protection.

So in Flood, per Chief Justice Strine, the Court began to close the holes.

First, it basically did away with MFW’s baffling footnote, which to be honest is more housekeeping than anything else.

And second, the Court held that “so long as the controller conditions its offer on the key protections at the germination stage of the Special Committee process, when it is selecting its advisors, establishing its method of proceeding, beginning its due diligence, and has not commenced substantive economic negotiations with the controller, the purpose of the pre-condition requirement of MFW is satisfied.”

In other words, a controlling shareholder may still take advantage of the MFW framework if it proposes the deal without the protections, and adds them later, so long as no “substantive economic negotiations” (and possibly other steps) have taken place in between.

Francis Pileggi also offers a very helpful analysis of the case.

Heartland Payment Systems sues ex-CEOs girlfriend for trading on inside information (sort of)

Back in June Reuters reported that:

The U.S. Securities and Exchange Commission on Tuesday charged the former chief executive of Heartland Payment Systems Inc and his romantic partner with insider trading ahead of the payment processor's $4.3 billion takeover by Global Payments Inc .

Robert Carr, Heartland's founder and CEO, was accused of telling Katherine Hanratty in November 2015 that Global Payments had offered to buy Princeton, New Jersey-based Heartland for a premium and giving her a $1 million check with instructions to open a brokerage account and buy $900,000 of Heartland stock.

Hanratty did what Carr asked, and sold her stock for a $250,628 profit in April 2016, four months after the merger was announced, the SEC said in a complaint filed with the federal court in New Haven, Connecticut.

Apparently Hanratty was not acting as a straw man for Carr, but rather was the beneficiary of a tip (quid pro quo in return for sexual favors or maybe just a gift) from Carr, as the SEC complaint alleges:

On November 23, 2015, Hanratty emailed Carr to express her gratitude and stated “for the first time ever I feel a sense of relief knowing that I have some security.” Referring to the $1 million, Hanratty repeated that “I have done exactly what you recommended I do with it and made you the beneficiary of the account.” Carr replied via email that he was glad that she was not so stressed anymore.

So far all of this seems pretty run of the mill. Slam dunk for the SEC is the phrase that comes to mind. And, indeed, Fox reported that Hanratty settled the SEC charges and paid disgorgement of her profits and a $250,000 fine.

But here's where it gets interesting. Bloomberg is now reporting that:

Heartland Payment Systems LLC is suing its former CEO’s girlfriend for making insider trades based on tips he passed on about an upcoming merger. ...

In fact,  Heartland is suing both Hanratty and Carr. Count I of the complaint alleges that Carr breached his Delaware corporate law fiduciary duty by disclosing the information to Hanratty. Count 2 alleges that Hanratty added and abetted Carr's breach in violation of state corporate law.

This is a very unusual suit. It's rare that an issuer sues an employee (even a former employee) for alleged insider trading. Not unheard of, but rare. As Richard Booth explains:

So why is it that issuers seldom seek disgorgement on their own? It is possible that the practice is common and quietly handled, but I doubt it. One obvious reason that issuers do not often sue their own for insider trading is an inherent conflict of interest. It is often the case that the culprits have the power to decide whether the corporation should sue. Still, that does not explain why there are few derivative actions in connection with insider trading. On the other hand, it appears that the number of derivative actions brought in tandem with securities fraud class actions has been increasing in recent years. Another somewhat less obvious reason for the disinclination of issuers to go after inside trading is that it might often amount to an admission that the company failed to disclose material information in a timely fashion and might trigger the filing of a securities fraud class action. Thus, as I have argued elsewhere, the disproportionate threat of securities fraud class actions and their potentially devastating collateral consequences may prevent publicly traded companies from self-policing.

Richard A. Booth, The Missing Link Between Insider Trading and Securities Fraud, 2 J. Bus. & Tech. L. 185, 206 n.104 (2007).

The fact that Heartland had had a change of ownership may be pertinent. The new owners may have had a beef with Carr.

So what will Hearland have to prove to win against Hanratty? “The elements of a claim for aiding and abetting a breach of a fiduciary duty are: (1) the existence of a fiduciary relationship, (2) the fiduciary breached its duty, (3) a defendant, who is not a fiduciary, knowingly participated in a breach, and (4) damages to the plaintiff resulted from the concerted action of the fiduciary and the non-fiduciary.” Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d 160, 172 (Del. 2002)

As for # 2, what Carr allegedly did was a breach of Delaware fiduciary duty law. Delaware courts have recognized a "a corporate claim for insider trading" based on the duty of loyalty. Pfeiffer v. Toll, 989 A.2d 683, 704 (Del. Ch. 2010), abrogated on other grounds by by Kahn v. Kolberg Kravis Roberts & Co., L.P., 23 A.3d 831 (Del. 2011):

The plaintiff must show that: “1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information.”

Kahn v. Kolberg Kravis Roberts & Co., L.P., 23 A.3d 831, 838 (Del. 2011).

Dual class stock sunset provisions

Dual class stock capital structures have long been controversial. See my article The Short Life and Resurrection of Sec Rule 19c-4. Washington University Law Quarterly, Vol. 69, Pp. 565-634, 1991. Available at SSRN: https://ssrn.com/abstract=315375.

In my Business Associations class yesterday, we were talking about dual class stock and I mentioned that the Council of Institutional Investors wants dual class stock structure to come with a sunset provision. CII is starting to have some success in pressuring issuers going public to include such sunset provisions:

This strikes me as an appropriate market-based response to the issues raised by dual class stock, obviating the need for SEC rules or stock exchange listing standards.

Empirical Evidence on the Im pact of SB 826: Gender Quota Mandate for Boards of Directors

Hwang, Sunwoo and Shivdasani, Anil and Simintzi, Elena, Mandating Women on Boards: Evidence from the United States (October 13, 2018). Available at SSRN: https://ssrn.com/abstract=3265783

On September 30, 2018, California became the first US state to mandate women directors on corporate boards. The passage of this law resulted in a significant decline in shareholder value for firms headquartered in California. The decline in shareholder value is directly related to the number of female directors that firms are required to add to the board. We argue that supply-side constraints contribute to the costs imposed by the mandate. The expected costs of additional female directors are higher for firms that face a more limited director pool and for those with weak corporate governance. Our findings indicate that mandated increases in gender diversity on corporate boards are detrimental to shareholder value.

The Commonsense Corporate Governance Principles Round 2

A group of 21 CEOs and institutional investors have released  Commonsense Principles of Corporate Governance 2.0:

A little more than two years ago, we published the Commonsense Principles of Corporate Governance.  That work represented a collaborative effort – a search for common ground – by representatives of some of America’s largest corporations and institutional investors.  We said then, and it is no less true today, that the long-term prosperity of millions of American workers, retirees and investors depends on the effective governance of our public companies.  We hoped that our Principles would be part of a larger dialogue about the responsibilities and need for constructive engagement of those companies, their boards and their investors.  We think that has been the case.  Other groups have published their own works on the subject.  Among them are an investor-led effort by the Investor Stewardship Group (ISG) called the Framework for U.S. Stewardship and Governance, a business-led effort by the Business Roundtable (BRT) called Principles of Corporate Governance, and a piece by the International Business Council of the World Economic Forum called The New Paradigm. ...

Today, we endorse the ISG Framework, the BRT Principles and The New Paradigm as counterweights to unhealthy short-termism.  Indeed, a number of the companies and organizations represented in those efforts were also part of ours.  Moreover, in light of the work of the ISG, the BRT the World Economic Forum and others, and after further reflection on our own Commonsense Principles, we decided to re-convene and revise the Principles – we call them Commonsense Principles 2.0.  Ultimately, we hope that the many sets of corporate governance principles currently in circulation can be harmonized and consolidated, and reflect the combined views of companies and investors.  We do worry that dueling or competing principles could impede, rather than promote, healthy corporate governance practices.

We are also today making a commitment to apply the Commonsense Principles 2.0 in our businesses – and we hope others will do so as well. 

I critiqued version 1.0 as offering "Some feel good platitudes. Some commonsense. And some pure bunkum." And defended that conclusion against attack.

On quick glance, it looks like the same critique applies to the new version. I may give it a more detailed review later.

 

Sullivan & Cromwell, Keith Paul Bishop, and Yours Truly on California Board of Director Quota Law

Sullivan & Cromwell:

On September 30, 2018, Governor Brown of California signed into law a bill, SB-826, to require female representation on the boards of directors of publicly traded companies who identify as being headquartered in the state.  SB-826 makes California the first state to attempt to enact female gender quotas for boards of directors.  SB-826 will become effective on January 1, 2019 and will require companies subject to the legislation to comply with the first phase of requirements (requiring boards of directors to have at least one female member) no later than December 31, 2019. ...

The California Secretary of State is required to assess compliance annually and is empowered to impose fines for noncompliance.  Any corporation subject to Section 301.3 that fails to file on a timely basis information about its board members with the Secretary of State may incur a $100,000 fine.  The content and timing of required filings with the Secretary of State will be established through regulations that have not yet been issued.  Separately, a corporation’s first failure to have the requisite number of female directors may result in a $100,000 fine and each subsequent violation may result in a $300,000 fine. ...

Even if SB-826 is ultimately invalidated, the legislation reflects the growing sentiment in favor of diversity for boards of directors.  According to Institutional Shareholder Services (ISS), more than 80% of investors and 60% of non-investors (including corporate directors and other market constituents) who participated in the ISS 2018 governance principles survey believed it would be problematic if a board of directors did not include any female members.  Glass, Lewis & Co. has indicated that beginning in 2019 it will generally recommend against election of the chair of the nominating committee of any Russell 3000 company having an all-male board, and ISS is reported to also be considering adopting a similar policy.  Large institutional investors, including State Street Global Advisors, Inc., BlackRock, Inc. and The Vanguard Group, Inc., have also indicated that gender diversity on the board of directors may influence their voting decisions.

Keith Paul Bishop on what female means for purposes of the new statute:

Given the substantial penalties that may be assessed for failure to have the prescribed minimum number of female directors, who counts as a female director could be an important question.  The legislature provides a Delphic answer ("γνῶθι ἑαυτόν") by defining a "female" for purposes of the gender quota requirements as "an individual who self-identifies her gender as a woman, without regard to the individual’s designated sex at birth".  Cal. Corp. Code § 301.3(f)(1).  

Keith Paul Bishop on the tasks assigned to the California Secretary of State's tasks under the statute:

One of the first tasks will be for the Secretary of State's office to publish a report on its web site "documenting the number of domestic and foreign corporations whose principal executive offices, according to the corporation’s SEC 10-K form, are located in California and who have at least one female director".  Cal. Corp. Code § 301.3(c).  The deadline for this report is July 1, 2019.  One difficulty that the Secretary of State will be to determine the gender of directors inasmuch as the Securities and Exchange Commission has no gender disclosure requirements.  Although many first names are traditionally associated with a gender, many (such as Kim) are not.  Implementing this requirement also will likely require the Secretary of State to promulgate rules interpreting the statute and adopting forms.  See Cal. Corp. Code § 301.3(e).  Rulemaking under California's Administrative Procedure Act is a time consuming process that requires public notice and comment.  While the Secretary of State may choose to adopt emergency regulations, this would require a finding that immediate action is required to avoid serious harm to the "public peace, health, safety, or general welfare".  Cal. Gov't Code § 11342.5.

The Secretary of State is also charged with enforcing the new law and is authorized to impose fines on violators.  Although the Secretary of State does have some existing investigative and enforcement powers with respect to notaries and elections, it has not have substantial experience as a civil prosecutor.  The office will undoubtedly need to add staff and adopt regulations to carry out these new tasks.

Lastly, yours truly on whether the bill will survive constitutional scrutiny under the dormant commerce clause.

Nevada Supreme Court keeps de facto merger doctrine alive

Keith Paul Bishop:

Last month, Professor Stephen Bainbridge posed the question of whether California recognizes the de facto merger doctrine outside of the successor liability context.  Here was my response.  Less than two weeks later, the Nevada Supreme Court addressed the same question under Nevada law in  Peddie v. Spot Devices, Inc., 2018 Nev. Unpub. LEXIS 901.  

In an earlier decision, Village Builders 96, L.P. v. U.S. Laboratories, Inc., 121 Nev. 261 (2005), the Nevada Supreme Court identified the following four factors in determining whether to apply the de facto merger doctrine:

• Continuity of enterprise
• Continuity of shareholders
• Seller's cessation of ordinary business operations; and
• Assumption of seller's obligations.

In Peddie, the plaintiff in a dissenters' rights action challenged two debt-to-equity transactions, one in 2011 and one in 2013.  The Supreme Court upheld the trial court's finding that the de facto merger doctrine did not apply to the earlier transaction because the plaintiff had failed to make a prima facie case as to three of the Village Builders factors.  The plaintiff succeeded in obtaining a reversal of the trial court as to the second transaction which involved the forgiveness of debt and the transfer of the corporation's remaining assets. 

Interesting. I still think de facto merger makes no sense in the merger/asset sale context. 

How often does the Multistate Bar Essay Exam Test Business Associations Topics?

I ran across this Barbri chart while looking up corporate opportunities:

I cover everything but proxies in the basic Business Associations class. Proxies get bumped into Advanced Corporation Law.

Replacing the Board: Henderson and Bainbridge's "New Book Explores the Benefits of Outsourcing Corporate Governance"

From the University of Chicago Law School:

In his new book, Outsourcing the Board: How Board Service Providers Can Improve Corporate Governance (Cambridge University Press), he and UCLA School of Law Professor Stephen M. Bainbridge propose giving corporations the option of hiring a new kind of firm, a Board Service Provider (BSP), to serve as their boards. Today, corporations hire law firms, accounting firms, and consulting firms to give them the expertise needed to run their highly complicated businesses. So why not a corporate governance firm?

“There is a whole literature that precedes us advocating for professional board members with standards and education,” Henderson said. “But even that plan has shortcomings because it focuses on the individual rather than on the entity. If there were firms that provided board services and that had employees with expertise in all the areas these corporations need, that would be much more efficient than 12 part-time people. The firm could hire all the experts they need and have them down the hall when information is needed.”

...

“Right now, all that most boards have time for is oversight, but a BSP could spend time on other things because it would be a deeper entity, it would employ all the people it needs, and therefore, could be in compliance at a lower cost,” Henderson observed.

He also explained that BSPs, with their teams of experts, could overcome other corporate problems, such as having to make decisions without full information from management.

On the need for a populist response to "The Problem of Twelve"

John Coates has an interesting new paper out:

Three ongoing mega-trends are reshaping corporate governance: indexing, private equity, and globalization. These trends threaten to permanently entangle business with the state and create organizations controlled by a small number of individuals with unsurpassed power. The essay focuses on indexation. After providing background, the essay describes the rise of and reasons for indexation, noting that “passive” indexed investing takes a variety of forms. Data on indexation are presented — with the bottom line that indexation has progressed farther than most realize, because foreign ownership, institutional indexation, and “closet” indexation are often neglected by observers. Index providers’ incentives, resources, and methods are reviewed, with an emphasis on the how such providers have greater practical importance than simpler analytical approaches might suggest. The essay ends with an outline of policy options, and preliminary analyses of which seem likely to address the “Problem of Twelve” — the likelihood that in the near future roughly twelve individuals will have practical power over the majority of U.S. public companies.

Coates, IV, John C., The Future of Corporate Governance Part I: The Problem of Twelve (September 20, 2018). Available at SSRN: https://ssrn.com/abstract=3247337

Coates points out that:

The prospect of twelve people even potentially controlling most of the economy poses a legitimacy and accountability issue of the first order – one might even call it a small “c” constitutional challenge. Large companies have always tried to influence the law to protect or extend the power of those in control of those companies, through litigation and lobbying, among other means. In the late nineteenth century, the polity responded by passing antitrust laws, using those laws to break up large companies, banning corporate participation in elections, creating an administrative state, and legalizing labor unions. Together, those responses can fairly be seen as a small “c” constitutional response to the threat posed by the concentration of economic and political power created by the country’s first merger wave.

I think Coates has pointed out a genuine problem, which crystalizes an inchoate concern that has motivated both left- and right-wing populists in recent years. As I document in my own recent paper, Corporate Purpose in a Populist Era, available at SSRN: https://ssrn.com/abstract=3237107or http://dx.doi.org/10.2139/ssrn.3237107, I describe the historical concerns of right of center populists with concentrated corporate power:

Some populists were simply doubtful of the corporation’s fitness for purpose, disputing its utility as a way of organizing production.^[1] More often, however, right-wing populists objected to the separation of ownership and control inherent in the corporate form, arguing that it separated ownership from responsibility.^[2] This concern was not driven by populist sympathy for investors, which is the concern most modern scholars associate with the separation of ownership and control, but rather with the lack of social accountability inherent in dispersed and distant ownership.^[3] The Agrarians believed modern corporate capitalism had created a new class of absentee owners, which had broken down older systems in which owners and laborers had recognized their mutual obligations.^[4] The Agrarians thus echoed Berle’s contemporaneous complaint that the ownership structure of modern corporations divorced ownership and control,^[5] but added to it the further complaint that the public corporate form divorced a business’ owners from the firms workers and the local communities within which the firm did business.^[6]

The Agrarian ideal was small business with local owners who were embedded in the community.^[7] Whether it was ever practicable to restore such a bucolic utopia—assuming one ever existed—in a modern industrial economy is highly doubtful.^[8] But even if it were, what the Agrarians—among others—failed to understand is that the separation of ownership and control in the corporation is a feature and not a bug.^[9] Only the very smallest and most highly localized businesses could exist without separating ownership from control.^[10]

In general, most right-wing populists came to recognize that the problem was not the corporate form as such, acknowledging that the corporate form could be used advantageously even by locally owned and operated businesses.^[11] The problem thus was not the form itself but rather the massive power wielded by the very largest corporations.^[12]

Size and the resulting potential for concentrated economic power are thus recurring themes in the populist critique of the corporation. Late 19^thCentury populists thought that the growing power of corporations was a significant threat to their economic and even political liberty.^[13] The Southern Agrarians likewise believed, as Agrarian Lyle Lanier observed, that “the corporate form of our economic system makes possible a scale of exploitation unheard of in history.”^[14] In particular, the Agrarians saw large corporations as Leviathans trampling on their employees. The labor such corporations provided lacked security. It was performed under dehumanizing conditions. Yet, the law protected it by enshrining the rights of corporations into the constitution.^[15] The Southern Agrarians further believed that the concentration of economic power in large corporations had created “a plutocratic capitalist class” that effectively ruled the country and thus stood ready to fully exploit their power over farmers and workers.^[16]

Much the same set of concerns motivates many Tea Party members. In response to the Citizens United decision,^[17]for example, Tea Party co-founder Dale Robertson complained that “[c]orporations are not like people. Corporations exist forever, people don’t. Our founding fathers never wanted them; these behemoth organizations that never die. ... It puts the people at a tremendous disadvantage.”^[18] Tea Party activists also tend to be uncomfortable with business’ political agenda and business’ lack of support for Tea Party social issues.^[19] The inability or unwillingness of large corporations to assist in addressing “the political alienation and economic instability” felt by many gave rise to “both left- and right-wing populism” and helped elect Donald Trump.^[20]

Coates' analysis thus makes concrete the ways in which changing corporate governance demands the attention of populist reformers, so as to break up a concentration of power almost unprecedented in American economic history.

SB 826: Keith Paul Bishop Responds to the Standing Issue

Professor Bainbridge Asks "Would They Have Standing?" https://t.co/2eOni8vXMp

— Professor Bainbridge (@ProfBainbridge) October 8, 2018

But would they have standing?

Investors should sue California over its corporate gender quotas right now https://t.co/c7IFW8Owwg via @LibertyUnyieldi I'm not a standing expert, but would be interested in those who are analyzing the argument.

— Professor Bainbridge (@ProfBainbridge) October 7, 2018